Who’s afraid of a downgrade- asks Old Mutual Wealth
The dust has now settled somewhat following the disappointing Medium Term Budget and, lo and behold, markets are mostly up. While some have attributed this to relief that Moody’s decided not to downgrade the credit rating on government bonds to junk status, it’s not a very convincing explanation. After all, Moody’s made it clear that it needs to see concrete measures to stabilise the government’s debt ratios in the February Budget. That is only three months away.
A downgrade is therefore still very much on the cards. The more important question is how much should this concern investors. The short answer is that the broader context matters, but more on that later. Markets are up over the past week because global risk appetite has perked up, and South African assets usually benefit when this happens. For better or worse, we are highly geared to changes in risk appetite, as our deep and liquid financial markets mean investors can easily trade-in and out of local assets to express global views. The rand is also one of the most widely traded currencies among major emerging markets, according to the Bank for International Settlements (the central banks’ central bank) survey of foreign exchange turnover.
With the US and China agreeing not to escalate the trade war, and even possibly to roll back some of the past tariff increases, a big downside threat to the global economy receded. As it stands, the latest data available shows that, while global growth has slowed considerably, fears of a global recession were overblown. Manufacturing is definitely declining, though the worst seems to be over. Overall growth is still being held up by consumer spending in the developed world.
Indeed it is the weakness in manufacturing that is probably pushing the US to soften its stance on China. President Donald Trump faces an election in a year’s time. To win he needs to carry the so-called swing states – states that switch between supporting Republican and Democratic candidates. He particularly needs to repeat his performance in Wisconsin, Michigan and Pennsylvania, where support from blue-collar workers helped him win by razor-thin margins in 2016.
However, the latest employment surveys show manufacturing employment has declined in all three of these states in the past year. Overall US manufacturing is still adding jobs, and employment for the economy as a whole expanded 1.4% in the year to October. With wage growth steady but unexciting around 3%, it means overall household income growth is slightly more than 4%. With inflation below 2%, this implies decent real income growth that supports household spending, the largest driver of economic growth by far in the world’s largest economy. Therefore, the US economy is growing at a 2% annual pace in real terms (after inflation). The Eurozone is growing at 1%, and China at 6%. These growth rates are all lower, but remain positive.
Fed down, not up
Importantly, a year ago, the US Federal Reserve (the Fed) was still happily hiking interest rates and was promising to continue doing so into 2019. Instead, it cut rates three times. No further cuts are expected as we head into 2020, but nor are any hikes on the cards. The Fed and its sibling central banks are not going to be responsible for a global recession.
Chart 1: Global equities in US dollars
Source: Refinitiv Datastream
With downside risks having diminished, more investors can reach for upside in growth and high yielding assets. Global equity returns for 2019 to date are north of 20%. The panicky lurch lower in developed market bond yields, pushing many into negative territory, has also eased, though it is still very much a low global interest rate environment. This is a much safer global backdrop for South Africa, irrespective of progress or lack thereof on domestic challenges.
So what would a Moody’s downgrade mean? Firstly, South African government bonds are already rated sub-investment grade (‘junk’) by S&P Global and Fitch. The sky did not fall on anyone’s head when these downgrades happened, despite much wailing and gnashing of teeth. The simple reason is that markets react in real time to the information ratings agencies incorporate in their models. Ratings agencies make periodic announcements, but markets price the most likely future scenario in immediately. Moody’s is the last major ratings agency to maintain South Africa’s investment grade rating. This is not because it is more generous or patient than the other agencies, but reflects the fact that each agency has its own methodology.
Moody’s methodology places a large weight on institutional strength, and it is hard to argue that this has not improved over the past two years, even if the fiscal situation has deteriorated.